Large caps will beat small until year-end

Commentary: Manager year-end bonuses have big impact on market

CHAPEL HILL, N.C. (MarketWatch) — You might want to stay away from the riskier small caps for the next couple of weeks — until the end of December, in fact.

The reason is not that the bull market is getting rather long in the tooth, though that is definitely true. Nor is it because the U.S. might be headed over the fiscal cliff, though it most definitely might.

Instead, the reason to be conservative until the end of the year: The perverse incentives under which institutional money managers operate.

They dominate the market, and their compensation incentives lead them to make their portfolios look more and more like the large-cap dominated S&P 500
SPX, -0.17%
as the year progresses. This, in turn, causes small-cap stocks to be at their most unpopular in December.

Consider a money manager who, at the beginning of December, is ahead of the S&P for year-to-date performance. If he is like the majority of money managers whose performance bonus is based on outperforming that or a similar index, he will be under considerable pressure to lock in that lead by shifting his portfolio holdings away from small caps and in favor of holding the large-cap stocks that dominate the S&P 500.

A not dissimilar situation exists for a manager who is currently behind the S&P 500 for year-to-date performance. To be sure, he is not currently slated to earn any bonus for beating this benchmark. But he does have another incentive, one that is just as powerful, if not more so: To avoid ending the year’s rankings at or near the bottom, which carries a considerable amount of career risk.

Once January arrives, however, managers in both camps will have their compensation slate wiped clean. That, therefore, is when the incentive to take risks will be higher at any other time of the year — and that, in turn, translates into buying small-cap stocks.

One way of gauging the impact of these incentives is by measuring the relative strength of small-cap stocks over the large caps.

The returns in the following table are based on data from Eugene Fama of the University of Chicago and Ken French of Dartmouth; they place a stock in the small-cap category if its market cap is below the median of all NYSE-listed stocks, and in the large-cap category if above it. Their data set extends back to 1926.

December

January

Average of all months

Average small cap stock’s return minus average large cap’s return

-0.02%

2.28%

0.23%

For those of you who are taken by this theory about manager incentives and therefore are inclined to favor large-cap stocks over small caps until year’s end, here are the large-caps that currently are recommended by the greatest number of the advisers I monitor who have beaten a buy-and-hold in the stock market over the last 15 years:

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